The Use of Management s Prospective Financial Information by a Valuation Specialist. Mark L. Zyla CPA/ABV, ASA, CFA Acuitas, Inc.

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1 The Use of Management s Prospective Financial Information by a Valuation Specialist Mark L. Zyla CPA/ABV, ASA, CFA Acuitas, Inc. Atlanta, Georgia

2 Introduction Management typically prepares Prospective Financial Information ( PFI ) which is used as an input in a discounted cash flow model, a common valuation method. Current Best Practices dictate that Valuation Specialists should determine whether or not the PFI prepared by management is reasonable for use in their analysis. Today s presentation will focus on assessing the reasonableness of PFI for use by a valuation specialist. The basis of the presentation is the American Society of Appraiser s Business Valuation Committee Special Topic Paper #3 The Use of Management s Prospective Financial Information by a Valuation Analyst published in the Spring 2017 issue of Business Valuation Review ( Volume 36. Number 1)

3 The Use of PFI in a Valuation Analysis The three common components of the DCF method are: An estimate of future cash flows ( Prospective Financial Information or PFI ) An estimate of an appropriate risk-adjusted required rate of return used to discount the estimated future cash flows back to net present value Long term growth

4 Management s Prospective Financial Information: Difference between a Forecast and a Projection Financial forecast is the prospective financial statements that present, to the best of the responsible party s knowledge and belief, an entity s expected [emphasis added] financial position, results of operations, and cash flows. A financial forecast is based on the responsible party s assumptions reflecting the conditions it expects [emphasis added] to exist and the course of action it expects[ emphasis added] to take. American Institute of Certified Public Accountants, AICPA Professional Standards, AT Section 301 Financial Forecasts and Projections.

5 Management s Prospective Financial Information: Difference between a Forecast and a Projection Financial projection is the prospective financial statements that present, to the best of the responsible party s knowledge and belief, given one or more hypothetical [emphasis added] assumptions, an entity s expected financial position, results of operations, and cash flows. A financial projection is sometimes prepared to present one or more hypothetical [emphasis added] courses of action for evaluation, as in response to a question such as What would happen if? A financial projection is based on the responsible party s assumptions reflecting conditions it expects would exist and the course of action it expects would be taken, given one or more hypothetical [emphasis added] assumptions. American Institute of Certified Public Accountants, AICPA Professional Standards, AT Section 301 Financial Forecasts and Projections.

6 Professional Standards and PFI ASA BVS-VIII If projections of balance sheets or income statements are used in the valuation, key assumptions underlying those projections must be included and discussed. American Society of Appraisers, ASA Business Valuation Standards

7 Professional Standards and PFI- USPAP ( Real Property) To avoid misuse or misunderstanding when DCF analysis is used in an appraisal assignment to develop an opinion of market value, it is the responsibility of the appraiser to ensure that the controlling input is consistent with market evidence and prevailing market attitudes. Market value DCF analyses should be supported by market derived data, and the assumptions should be both market and property specific. Market value DCF analyses, along with available factual data, are intended to reflect the expectations and perceptions of market participants. They should be judged on the support for the forecasts that existed when made, not on whether specific items in the forecasts are realized at a later date. The Appraisal Foundation, Uniform Standards of Professional Appraisal Practice

8 Professional Standards and PFI- IVS regardless of the source of the PFI (eg, management forecast), a valuer must perform analysis to evaluate the PFI, the assumptions underlying the PFI, and their appropriateness for the valuation purpose. The suitability of the PFI and the underlying assumptions will depend upon the purpose of the valuation and the required bases of value. For example, cash flow used to determine market value should reflect PFI that would be anticipated by market participants; in contrast investment value can be measured using cash flow that is based on the reasonable forecasts from the perspective of a particular investor. International Valuation Standards 2017 IVS 105 Valuation Approaches and Methods 50.13

9 What we can learn from the standards Valuation Specialist should make a determination of whether or not the PFI prepared by management is reasonable for use in performing the valuation. Understand the assumptions made in managements PFI. A good practice is to review with management the process of how and why PFI is developed. Understanding the assumption behind management s PFI increases the credibility and reliability of the valuation.

10 Mandatory Performance Framework and PFI Practice Professional Skepticism Evidential Self-skepticism Reasonably Objective Basis Reasonable and Supportable Understand Management s Approach to Developing the PFI. Understand Key Components of PFI. Assess the PFI for Reasonableness. Document the findings.

11 Understanding the Assumptions First step is to determine whether the PFI was prepared using a top-down or bottom-up approach. Top down typically begins with an assessment of the overall market and the subject company s potential market share. Bottom- up typically developed from spending plans from lowest level groupings in the company. ( Operating Expense Plan). Second step is to understand who was involved in developing the PFI. Marketing and sales Finance and accounting Third step, perform a math and logic check on the PFI, including internal consistency. Fourth step if possible, compare previous periods PFI to actual. Fifth step, compare assumptions to observable market metrics.

12 Consider Asking Questions of Management Revenue Growth Is expected growth in revenue due to an increase in price or volume or both? How does expected growth in revenue of the Company compare to industry growth? Is revenue growth achievable given the current conditions of company operations? How are new products or services considered in forecasted revenue? If so are corresponding expenses reasonable? Are new products under development? What is the basis for research and development expenses? Are forecasted capital expenditures consistent with the revenue growth assumptions?

13 Consider Asking Questions of Management Expenses Are operating expenses consistent with historical levels? Did management differentiate between fixed and variable costs? If there are variable costs, what do costs vary against? Are forecasted results consistent historical results? If not, why? In a business combination, do the forecasts consider any synergies from revenue enhancement and/or cost savings? Is it reasonable for management to forecast a much higher or lower growth rate compared to guideline companies or other industry metrics? Is it reasonable for management to forecast a much higher or lower profit margin compared to guideline companies or other industry metrics?

14 Observable Market Metrics A good benchmark to evaluate the reasonableness of management s PFI is industry data. The valuation analyst should compare the subject company s historical performance and management s PFI to those of the guideline publicly-traded companies. Comparison with guideline publicly-traded companies can also provide the valuation analyst with detailed industry information, such as normalized working capital level, average industry growth rate, and average capital expenditures. In addition, the valuation analyst might research market and industry research reports and relevant government data as additional information to determine whether or not the PFI is reasonable for use in a valuation.

15 Understanding Market Participant versus Entity Specific Synergies Which May be Modeled in the PFI. What is the purpose of the valuation? In a business combination measurement of fair value, the PFI should reflect those assumptions that a market participant would make rather than the assumptions that are specific to the acquiring entity. Are likely market participants strategic acquirers or financial acquirers? Strategic acquirers have potential operating synergies related to revenue, expenses, and cost of capital. Financial acquirers may have synergies related to cost of capital.

16 What are the Nature of the Synergies? Revenue synergies may be experienced by using the acquirers existing distribution channels to sell the acquired entity's products. Additional revenue synergies may be found by combining complementary products within existing channels. Potential synergies relating to cost reductions are the result of economies of scale and the elimination of duplicate costs. Examples of cost-reduction synergies would be the elimination of redundant workforces and a reduction in fixed costs from combining manufacturing and distribution facilities. Finally, there may be synergies related to the reduced cost of capital of the combined entities. For example, a start-up may gain access to capital at a lower rate as part of a larger, more stable entity.

17 Analytical Tools Begin with actual historical experience. Analyze actual growth in revenue and cash flow. Note actual profit and cash flow margins. Understand impact of certain economic indicators on company s results. Perform regression analysis of economic indicators to actual results for use in comparing projected information. Perform mathematical and logical checks on the PFI. Scenario analysis Identify key value drivers from historical experience. Monte Carlo simulations Compare assumptions in PFI to industry data. Document the analysis.

18 What if Management Doesn t Prepare a PFI or if the Valuation Specialist Doesn t Agree with Assumptions? Ask management to develop a PFI, or revise if necessary. Adjust the PFI. Disclose the magnitude of any adjustment. Disclose the rationale of the adjustment. Check other sources Company s outside financial advisors Review equity analyst s reports. Reconcile the results. Adjust the cost of capital for the additional risk Support the adjustment with adjusted PFI prepared by the valuation specialist for inclusion in workpapers. Rely on other valuation methods such as capitalization of cash flows and/or methods under the market approach.

19 Conclusions The valuation specialist should determine if the PFI provided by management is reasonable for use in a valuation analysis. Assessing for reasonableness means the valuation specialist should not simply accept management s PFI without understanding the underlying assumptions. ASA professional standards suggest that the valuation specialist should understand the nature of management s forecast (PFI) and underlying assumptions and discuss in the report. Good practice dictates that the analyst understand who prepared the PFI and the purpose for which it was prepared. Assessing the assumptions in the PFI for reasonableness can take many forms. However a proper assessment increases the credibility and reliability of the valuation.

20 Mark L. Zyla Managing Director of Acuitas, Inc., an Atlanta, Georgia based valuation and litigation consultancy firm. Chairman, Standards Review Board, IVSC Member of the ASA s Business Valuation Committee and the AICPA s FVS Executive Committee. Member of the working groups which developed the AICPA s Testing Goodwill for Impairment- Accounting and Valuation Guide and The Appraisal Foundation s The Identification of Contributory Assets and Calculation of Economic Rents. Author of Fair Value Measurements: Practical Guidance and Implementation 2 nd ed. published by John Wiley & Sons (2013) Co-author of four monographs on various aspects of fair value measurements published by BNA Bloomberg. Developed the education material for the CEIV credential for the AICPA and RICS. Inducted into the AICPA s BV Hall of Fame in 2013 Member of the Master of Science in Finance Advisory Council at the University of Texas at Austin.

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